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Politics may impede government ability to deal with long-run fiscal crisis

Advanced economies must take steps soon to address high and growing government debt and deficits even as many have to maintain stimulus programs for the next year or so to deal with lingering effects of the recent global recession, a panel of leading economists agreed at an IMF-sponsored forum.

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Bringing government spending in line with revenue over the longer run—what economists call fiscal consolidation—must involve carefully designed programs that, depending upon the country, involve tax increases, expenditure cuts and structural reforms that enhance long-run growth prospects. “The pace and composition of consolidation matters,” Antonio de Lecea of the European Commission said at the roundtable that concluded a two-day conference on “Fiscal Strategies after the Global Crisis,” April 22 and 23.

They also need enhanced revenue sources. Not only do aging populations increase pension costs, retired people also pay fewer taxes, said Takatoshi Ito, of the University of Tokyo. In Japan, debt as a percentage of gross domestic product already approaches 230 percent, by far the highest of the advanced economies.

The need to act soon to deal with fiscal issues is given heightened urgency by the prospect that interest rates will rise in the not far off future as the nascent economic recovery continues and monetary policy measures adopted during the crisis are withdrawn, according to Pier Carlo Padoan, chief economist of the Organization for Economic Cooperation and Development.

Higher rate woes

Investor worries that governments will not be able to pay their debts in full, so-called sovereign risk, could add to interest rate increases. Higher rates not only add to fiscal woes by increasing the interest governments must pay on their debt, they also could damage economic growth in advanced economies.

And the medium-term growth outlook in advanced economies already is “lousy,” according to David Romer of the IMF and the University of California, Berkeley. Romer said that taking proper steps now could allow governments to engage in additional stimulus if necessary, while creating confidence among investors that governments are “serious about tackling the long-run problem.” By designing programs well, “you can use the long-run consolidation to actually help the economy in the short run,” Romer said.

The economists were in general agreement that those early steps should include increases in the retirement age to more accurately reflect longer lifespans as well as increases in non-distortionary taxes or a reduction of tax breaks and other distortions in existing taxes. Most of the economists said the primary tax of choice is the value-added tax, essentially a levy on consumption.

Lesson learned

The economists also agreed that a major lesson from the crisis that began in 2007 is the importance of a healthy fiscal situation in good times so that governments have the financial ability (called fiscal space) to respond to rising unemployment, declining growth, and falling tax revenues in a recession.

Douglas Elmendorf, Director of the U.S. Congressional Budget Office, said having the U.S. budget deficit and debt relatively low before the crisis permitted the necessary fiscal actions that were “crucial for resolving the financial crisis and mitigating the harm of the subsequent recession.”

Politics a problem

Yet politics makes it difficult to prepare for bad times because the bias is always toward spending or, in some countries, toward tax cuts. When the money is available, say when tax revenues are higher than expected, politicians want to spend them rather than use them to reduce debt, said the University of Tokyo’s Ito. And when recession hits, politicians see a need to spend as well, he said.

The economists were pessimistic that politics would change sufficiently to permit unpopular spending cuts, tax increases, and structural reforms to take hold.

Carlo Cottarelli, Director of the IMF’s Fiscal Affairs Department, said he does not see any indication that the political climate in most major countries will permit a sufficient “adjustment in the level of public debt.”

For the last 40 years, he said, in remarks summarizing the roundtable, the public debt-to-GDP ratio has been increasing on average across the world. “Every time there was a shock, public debt went up. Then it stabilized. Then it went up again . . . Something must happen to make this change.”

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